Bitcoins: Financial innovation Japanese-style
By Oliver Haill
Date: Monday 15 Apr 2013
Money is many things to many people and almost everything to a few. So then, just what are bitcoins? The explanations are probably about as varied. They are different things to different people. However, at their simplest bitcoins seem to be the latest ‘commodity.’ Yes, some people accept them as a means of exchange, as is expected of a currency, but it remains to be seen whether they will turn out to be an acceptable ‘store of value’ and there is certainly no government standing behind them.
On Wednesday, the value of bitcoins, the virtual currency or ‘crypto-currency’ set up four years ago by computer programmers going by the name of Satoshi Nakamoto, rose to the highest peak in its four-year lifetime. It then proceeded to lose over half its value in a matter of hours. The exchange rate with the US dollar crashed from a price of $266 to $105 before bouncing back to $160 within six hours and since then drifting away to $120 at the time of writing (on the Friday after this article was written they hit yet another low of $54.25) .
In fact, as this is quite a long article, by the time it gets edited and you finish it, the price may have halved or doubled again. So good luck.
Nevertheless, such a phenomenon is intriguing for what it may tell us of current times. Is it a product of financial innovation? Or just a way to get around the tax-man? A means of averting central bank-fueled inflation? Not coincidentally perhaps, it was born in Japan after all.
Since the start of the year the value of bitcoins has mushroomed more than 1,500%. While we’ve seen bubbles before, from tulips to dotcoms, this is new territory in the unregulated wilds of the internet.
Birth of the bitcoin
Rather than just a currency that is only available ‘online’ in certain stores or fantasy worlds such as Facebook ‘credits’ or ‘Linden’ dollars in the Second Life game, this electronic money is designed to be used as a payment mechanism for any and all transactions online.
In fact, bitcoin business solutions company BitPay has now integrated Amazon fulfilment in its offering and has reported having more than 1000 merchants accepting the currency under its payment processing service.
The process of generating bitcoins is not beyond the capability of many computer owners but these days requires a fairly massive chunk of processing power. Hence, the currency is often created by groups, or ‘pools’ of users, in a process called ‘mining’, employing their combined computer processing power to discover blocks of 50 bitcoins at a time – although now the market is becoming dominated by professional miners.
Once the mining process discovers a block of bitcoins, they are divided among the pool and stored on the user's hard drive in a virtual wallet. Each coin has a registration number by which they can be transferred between people, ‘peer-to-peer.’
This slow release of bitcoins onto the market mimics how mining companies unearth gold and other precious metals. The software has been written so that it becomes increasingly tough to produce new bitcoins, with the amount in circulation currently designed to eventually hit a maximum of 21m, with roughly 10m bitcoins in existence at present.
It has been calculated that the limit will be reach in the year 2140 – when ‘peak bitcoin’, like peak oil, perhaps, is attained – freezing the money supply at 21m bitcoins in existence. In the decades up to that point, the supply of Bitcoins will almost stagnate, probably creating deflation.
Enter Cyprus: If you were to design a currency…
According to the Bitcoin Foundation, “cryptography is the key to bitcoin’s success”. The byzantine strings of code are the reason that no-one can double-spend, counterfeit or steal bitcoins, the foundation claims – although a number of frauds have already been effected.
Initially the domain of serious internet geeks – or the “anarcho-utopian crowd of techno-libertarians who drive an enormous amount of innovation online” as Reuters blogger Felix Salmon describes them – and those excited by the idea of the internet minting its own currency or making an investment that was not beholden to any central authority, interest in bitcoins has surged and so has its value.
No surprise then that many observers claim the recent appreciation of the virtual currency has been fuelled by Cypriots and Russians transferring their savings during the island’s banking crisis.
There are exchanges that swap bitcoins for real-world currencies, where many former Nicossia and Limassol bank customers have supposedly been flocking. Tokyo-based Mt.Gox has become the most established bitcoin exchange and a major player in the burgeoning market, recently sealing a deal with venture capital-backed Bitcoin CoinLab to provide US and Canadian customers with a new exchange platform specifically catered to this market's unique needs.
Further acceptance, at least among the world of high-risk financial products, has come with the formal launch of the first bitcoin hedge fund by Malta-headquartered Exante. With 80,000 bitcoins under management at launch, the fund had 0.73% of the entire supply of the currency at the time.
Risks inherent
M Peter Vessenes, Chairman & Executive Director of the Bitcoin Foundation, admits that while there’s “a lot to love in Bitcoin-land” there’s also plenty to be concerned about, too. “There are botnet operators, hackers, and ponzi-scheme runners floating around our space.”
As well, and unlike with your bank, there are no password recovery options with Bitcoin, so if you forget your password your funds will be permanently lost.
The currency has also occasionally faced threatening statements from government representatives and legal questions too.
But so far, most of the threats have been a lot less official. This year there has been distributed denial of services (DDoS) attacks on the Mt.Gox exchange, a discovery of a serious flaw in Bitcoin ‘mining’ software, the Bitcoinia site that allowed shorting in the currency was hacked twice and lost almost $300,000 of client funds, and Kaspersky discovered a new malware that was turning infected computers into “miner rigs” for its nefarious owners to generate bitcoins. Among other glitches and scams.
Outside of this threat from outside, perhaps the greatest weakness of bitcoin is the limited number of exchanges dealing in the currency and hence the reliance on Mt.Gox. All payment processors, such as bitpay, depend on the Tokyo-based exchange.
Thus, when Mt.Gox shut last Thursday, it may have contributed to the price spiralling even lower. There was less supply, but also hardly any demand.
Enter the regulator
Without mentioning bitcoins by name, the US Financial Crimes Enforcement Network (FinCEN) clarified the status of such monies under anti-money-laundering laws, saying those involved in exchanging decentralised virtual currency for real currency were obliged to register as a money services business and obey existing regulations as they would for centralised virtual currencies, such as Facebook credits.
Nevertheless, Patrick Murck of the Bitcoin Foundation called the guidelines "infeasible for many, if not most, members of the Bitcoin community to comply with".
Back in October, the European Central Bank (ECB) also investigated bitcoin and other previously unregulated virtual currencies. The investigation’s conclusion was that although they could become a "challenge" to government authorities, such currencies do not now pose a threat to price stability at its size at the time, but “this would change if a scheme would become significantly large”.
“It is mostly the holders of the currency that face risks, including the risk of a complete loss of the monetary value.”
A victim of their own ‘success:’ Bitcoins’ function as a currency (or as a commodity)
At the moment Bitcoin is more similar to a commodity than a currency. It has more than just a few parallels to the properties of gold, not least from the fact that it is “mined”. Then again, few national currencies float truly free on the forex market, with governments exercising, or at least attempting to, some control over their value as the concept of “currency wars” indicates.
Historically, as well, for some the demise of the Gold standard after the First World War shows how too slow a rise in the supply of the ‘yellow metal,’ especially when hoarded by some, can turn it into a handicap for an economy.
Societe Generale analyst Sebastien Galy, who was one of the first analysts to provide comment on bitcoins, argues that “if the bitcoin becomes too expensive it loses its usefulness as a numeraire [unit of account] used for exchange”.
Mark Thompson, head of corporate desk at Global Reach Partners, also a qualified technical analyst, gave me his opinion on this: “Bitcoins don’t have a central bank behind them to control liquidity and as such are prone to speculative bubbles, price spikes and crashes. From a volatility point of view its fairly high risk.”
Or as was put another way, by Mr Salmon: “It’s a bad idea to turn a currency into a commodity, because if the price of the commodity goes up, then everybody using the currency suffers from enormous deflation. Imagine a sucker who took out a loan in bitcoins a few weeks ago — she’d never be able to pay it back today. That’s a pretty good sign that bitcoins don’t work as a currency.”
So should you ‘invest’?
Jay Elliot-Purdy from Easy-Forex UK told Sharecast: “Any asset class that is in a bubble is pushed up mainly by those buying it because of the hype rather than because they think the asset will have greater value in years to come.”
“Sophisticated investors will invest in bubbles relying on the ‘crazies’ to keep pumping money into it believing the upturn will never end,” he says. “The sophisticated traders will then pull the plug, a crash will occur which will correct the value of bitcoins down to a true level.”
As Thompson adds: “If companies start to turn to it as an alternative to conventional money then realistically yes it would be something that we would take a look at."
Being a ham-fisted currency trader at the best of times, for me it’s too early to tell which way it’s going to go. However, like many gold investors who have seen the price of the yellow metal come off nearly 20% since its 2011 high, I am tempted purchase a bitcoin or two to hedge my bets.
Given that even single transactions can move the price of Bitcoins, it might be interesting to see what would happen if everyone took that advice.
Email this article to a friend
or share it with one of these popular networks:
You are here: news
10 Lower Thames St,
London EC3R 6EN